Fed to Markets: Come on Baby, Let’s Do the Twist

The Fed has resurrected an old tool of monetary policy. The central bank will buy longer-dated Treasury bonds and sell shorter-term notes. It’s based on a 1961 policy that the Fed implemented called “Operation Twist.”

(Ironically, on this week in 1960, Chubby Checker’s cover of “The Twist” hit number 1 on record charts.)

The notion is pretty simple. By buying longer-dated Treasurys, prices will rise and long-term interest rates will fall. Lower long-term interest rates may help spur investment. By selling short-term securities, their prices will fall and their yields will rise, attracting foreign capital.__________________________________________________________

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For the average investor, the potential changes could be huge. If the Fed is successful in lowering long-term rates, investors could get even lower rates on mortgages, while enjoying higher rates on short-term investments like T-bills and money market accounts.

Simply put, if all goes according to plan, Operation Twist would lower expenses and increase income for most investors.

Fed Chairman Ben Bernanke
(Getty Images photo)

Unfortunately, even with history as a guide, the first Operation Twist was so modest in scope that it’s difficult to determine if it will work now. Most economists of the era are of the opinion that it was ineffective.

The program remains smaller in scope than the Fed’s quantitative easing programs. Only $400 billion will be re-deployed in this operation through the end of June 2012.

Despite the smaller size and the fact that this policy won’t make any substantial changes to the size of the Fed’s balance sheet, the program received three dissenting votes from the Fed’s 10-member committee.

With this weak showing in the economy, the Fed left interest rates unchanged, in line with its earlier meeting announcement to keep interest rates near zero through mid-2013.

Negative data coming out in the past few months shows that the economy continues to weaken.

In the second quarter of 2011, U.S. GDP grew at a weak 1 percent.

Over the past few Fed meetings, the central bank has still not ruled out other means, to stimulate the economy and keep asset prices from plunging.

Many market watchers expected Operation Twist to take precedence over another round of quantitative easing, as the first two rounds of the controversial program did little to stimulate the economy. Some economists derided the program as mere money-printing that fueled inflation.